The Fed's latest plan to boost the economy: The most likely course of action is a new bond purchase plan similar to the "Operation Twist" policy that was launched in September and ends this coming June…. [I]f the Fed accepts risky long-term assets in exchange for lower risk assets such as T-bills, the amount of risk held in the private sector falls. The reduction in private sector risk hopefully makes individuals and businesses more confident and hence more willing to spend or invest. But the main effect comes through a second channel, the impact on long-term interest rates. The reduction in the supply of long-term assets in the private sector puts downward pressure on long-term interest rates….
Under Operation Twist, the Fed sells short-term assets off of its balance sheet and then uses the cash it raises from the sale to buy long-term assets. Under the present proposal, the Fed would borrow the money from the private sector in what is known as a reverse repo, and then use the money it borrows to purchase long-term assets. The loans from the private sector are short-term, and the Fed continues to roll them over until the longer term assets mature….
Why do it this way instead of simply repeating Operation Twist? The main reason is that the Fed is running out of short-term securities…. Instead of selling a piece of paper to the public labeled "bond" as in Operation Twist, the Fed gives the public a piece of paper that is an IOU -- a loan -- and those loans can be made in practically unlimited amounts….
The new policy under discussion at the Fed is an attempt to lean toward the dovish side -- to do something to help the economy -- without causing the inflation hawks to block the action…